CBE Monetary Policy 3 — Questions and Answers
Question 1: A contractionary monetary policy stance is most appropriate when an economy experiences:
- Rising unemployment and falling prices
- Negative GDP growth alongside trade deficits
- Overheating with inflation above the central bank's target (Correct answer)
- Declining business investment and weak consumer confidence
Correct answer: Overheating with inflation above the central bank's target
Contractionary policy (raising rates, reducing money supply) is used to cool an overheating economy and bring inflation back to target.
Question 2: The money multiplier in a fractional reserve banking system equals:
- 1 divided by the reserve requirement ratio (Correct answer)
- The reserve requirement ratio divided by the monetary base
- Total deposits divided by the federal funds rate
- M2 minus M1 divided by excess reserves
Correct answer: 1 divided by the reserve requirement ratio
The simple money multiplier is 1/r where r is the required reserve ratio; a 10% reserve ratio yields a maximum multiplier of 10.
Question 3: Which scenario illustrates the 'transmission mechanism' of monetary policy operating through the credit channel?
- Lower rates raise equity prices, increasing household wealth and consumption
- Rate cuts reduce bank funding costs, enabling more and cheaper business loans (Correct answer)
- Currency depreciation boosts net exports as domestic goods become cheaper
- Inflation expectations fall, reducing nominal wage demands in labor contracts
Correct answer: Rate cuts reduce bank funding costs, enabling more and cheaper business loans
The credit channel transmits monetary policy through changes in banks' cost of funds and their willingness to extend credit to businesses and households.
Question 4: The 'interest rate channel' of monetary policy transmission suggests that lower rates stimulate the economy primarily through:
- Increased government borrowing to fund infrastructure
- Higher business investment as the cost of capital falls (Correct answer)
- Reduced import prices lowering domestic inflation
- Rising commodity prices boosting mining sector employment
Correct answer: Higher business investment as the cost of capital falls
Lower interest rates reduce the hurdle rate for investment projects, encouraging firms to borrow and invest in capital goods.
Question 5: Sterilized foreign exchange intervention differs from unsterilized intervention because sterilization:
- Involves selling domestic bonds to offset the monetary impact of FX purchases (Correct answer)
- Uses only currency futures rather than spot market transactions
- Requires IMF approval before any central bank purchase
- Targets the real exchange rate rather than the nominal rate
Correct answer: Involves selling domestic bonds to offset the monetary impact of FX purchases
Sterilization offsets the domestic money supply effect of FX operations by simultaneously conducting an open market operation in the opposite direction.
Question 6: In the context of monetary policy, 'inflation targeting' requires a central bank to:
- Maintain a fixed exchange rate as the primary nominal anchor
- Publicly commit to a specific inflation rate and adjust policy to achieve it (Correct answer)
- Set money supply growth at a fixed percentage regardless of conditions
- Allow inflation to rise freely until unemployment falls to 4%
Correct answer: Publicly commit to a specific inflation rate and adjust policy to achieve it
Inflation targeting uses a publicly announced inflation goal (e.g., 2%) as the nominal anchor, with policy adjusted to keep actual inflation near that target.
Question 7: The 'sacrifice ratio' in monetary economics measures:
- The reduction in government spending required to stabilize the debt-to-GDP ratio
- The percentage points of GDP lost per percentage point reduction in inflation (Correct answer)
- The proportion of bank reserves held against long-term deposits
- The real interest rate conceded when issuing inflation-indexed bonds
Correct answer: The percentage points of GDP lost per percentage point reduction in inflation
The sacrifice ratio captures the output cost of disinflation: how much real GDP must be foregone to reduce inflation by one percentage point.
CBE Monetary Policy 3
A contractionary monetary policy stance is most appropriate when an economy experiences: